2/02/2007 @ 6:35PM

Naked Short Victim Strikes Back

Overstock.com
filed a $3.5 billion lawsuit in California state court Friday accusing 10 of the largest U.S. securities firms of participating in a “massive, illegal stock market manipulation scheme” to distort its stock.

The Salt Lake City online retailer, whose Chief Executive Patrick Byrne has been crusading against stock market trading abuses not just in Overstock shares but as a broad, pervasive market problem, said the banks’ actions caused “dramatic distortions” in how Overstock
shares were traded and lead to a dramatic decline in its price.

Overstock shares are down 77% in the past two years.

“These manipulative activities have caused tremendous damage to Overstock,” Byrne said in a statement Friday. “I believe that this conduct is harming our company and our shareholders deeply.”

Overstock’s lawsuit says the amount of stock that was improperly shorted has exceeded the company’s entire supply of outstanding shares. “It’s about rigging the system,” says Overstock’s attorney, James Christian.

Byrne’s self-described crusade against trading abuses over the last two years has brought a heap of criticism down on him, but regulators have acknowledged that there are loopholes that make the system ripe for abuse.

Going after the so-called prime brokers, the securities firms that provide stock lending and financing services to hedge funds, is another way to tackle the problem of naked short-selling, a manipulative trading tactic that can drive down share prices artificially and threaten the viability of small publicly traded companies.

Prime brokerage is one of the hottest businesses on Wall Street but little understood outside the world of finance. It essentially is the business of catering to hedge funds, acting as their trading counterparties, financing those trades, and loaning stock and other securities for funds to execute short-selling strategies.

According to Vodia Group, a New York firm that analyzes securities lending portfolios for traders at hedge funds and other asset managers, securities lending rakes in between $8 billion and $10 billion in annual revenues for Wall Street.

In regular short-selling, a trader borrows stock, sells it, and waits (or prays) for the price to drop before buying shares back to repay that loan and pocket the difference. There are rules for assuring that the shares have been properly borrowed, and everyone is supposed to abide them.

In naked short-selling, the trader sells the shares without properly borrowing the stock. When the stock isn’t properly borrowed, the buyer at the other end of that short-sale doesn’t get delivery of the shares within the mandated three-day window. The buyer also loses out on voting rights and tax-advantages until the short-seller closes out the position.

Now, fast working market makers are allowed to sell without borrowing to keep orderly markets. But naked short-selling as a strategy in and of itself is illegal. It is, however, highly tempting for both prime broker and hedge fund trader.

From the prime broker’s perspective, fees can be made by lending out the same sought-after shares to multiple traders at the same time. So prime broker A has 100 shares of Company A and lends 100 shares to trader X, 100 shares to trader Y and 100 shares to trader Z. Obviously 200 of those loaned-out shares don’t actually exist, and will result in a trade delivery failure.

From the trader’s perspective, a naked short can be less costly, since they have to pay more to borrow hard-to-borrow shares that are usually the choice targets of short-sellers anyway.

Having all those excess shares in the market artificially reduces the price of a stock, Overstock contends in its lawsuit. Overstock has been a regular on a list of Nasdaq-listed stocks that have large and persistent failures-to-deliver since that list started being published in January 2005.

It’s tough to say who is more at fault in naked short-selling, the hedge fund executing the short strategy without properly borrowing the shares, or the prime broker for either assisting or turning a blind eye to the practice.

In two suits filed last year in New York federal court, a small hedge fund and a small brokerage accused the same 10 banks named in Friday’s Overstock suit of charging them for services they never received. In other words, the prime brokers supposedly took their fees for stock lending services, but never properly lent them shares for their legitimate shorting strategies, unbeknownst to them.

Last summer, 40 investors in the Kansas City real estate investment trust
Novastar Financial
filed suit in California court against the same prime brokers, saying they were responsible for artificially suppressing Novastar stock by skirting stock lending and clearing and settlement rules.

Byrne has spent the last two years pushing legislators, regulators, and anyone else who will listen to reform the system. The Securities and Exchange Commission is combing through comment letters on proposed amendments to short-selling rules that could close some loopholes, but efforts in state legislatures to clamp down on brokerages have largely failed.

Last year, sympathetic lawmakers in Overstock’s home state of Utah shoveled a bill through the state legislature and got it signed into law after a special session in May. The new law would have forced brokerages to report trade delivery failures in shares of Utah companies to the state’s securities director within 24-hours, or face paying a sort of fine to those issuers.

But the Securities Industry and Financial Markets Association, Wall Street’s trade group in Washington, threatened a lawsuit in federal court and got the governor of Utah to capitulate on enforcing the law until June, supposedly to give the SEC time to reform the rules on a national level.

Several other bills in legislatures across the country have been stalled in the last few weeks by a similar threat of litigation by the industry group.